Westpac of interest as sector fundamentals start to turn

Thursday, May 30th, 2019

The four-year bank earnings downgrade cycle rumbled on after Westpac’s interim result, with downgrades of up to seven per cent to the bank’s fiscal 2019 and 2020 earnings per share by broking analysts even though expectations were already low before the result. Readers could be forgiven for thinking there is no end in sight to the pain, as the same negatives continue to weigh on earnings and returns. Analysts are focused on weaker housing and SME loan growth, interest margin pressure from price competition in mortgages and switching from higher-margin interest-only loans to lower-margin principal & interest loans, falling fee income, billion-dollar customer remediation costs, elevated legal, regulatory and compliance costs, rising retail borrower arrears and pockets of negative equity, loss of earnings from business divestments, potential adverse changes to negative gearing policies and reduced prospects for buybacks and special dividends due to regulatory uncertainty about capital. Reserve Bank rate cuts, which seem increasingly likely after the central bank shifted to a more cautious view of the economy in its recent Statement on Monetary Policy, would reduce deposit margins.

This is indeed a long list of negatives and it’s not over yet, with bank second half results set to look similar. But value investors with the temperament to tolerate further bad news and consequent share price volatility should prepare to be “greedy when others are fearful”, to quote Buffett. There could be moments during Westpac’s 2019 second half and 2020 first half when pessimism about earnings and returns creates opportunities to build out positions in a stock with a fully franked six per cent dividend yield and moderate earnings upgrade potential from 2021. Following this strategy will require looking ahead by around nine months, as this is beyond the market’s perennial focus on the next earnings result up to six months out.

The positive thesis for Westpac centres on things getting less bad over 2019-20 and the earnings downgrade cycle ending. We think house prices will bottom when buyers see value in housing again and population growth driven by immigration absorbs pockets of oversupply. New housing supply is tapering, evidenced by weakness in building approvals, so the ratio of demand to supply should evolve more favourably or less negatively, supporting a diminishing rate of house price depreciation in coming periods. In NSW, the ratio of housing demand to supply has already risen from 19-year lows.

Stimulus in the form of tax cuts, once enacted, may be back-dated to 1 July and should increase borrowers’ ability to service and receive approval for mortgages. Ongoing increases in funding for education, healthcare, aged care and disability support should drive further employment growth in these sectors, admittedly temporarily offset by lower employment in dwelling construction.

The domestic yield curve is inverted, signalling the policy cash rate is too high. RBA rate cuts would help to stabilise the housing market and banks would likely use them as an opportunity to reprice mortgages, particularly as this will be after the election. Mortgage repricing was an important support to interest margins in Westpac’s first half. RBA rate cuts would also restore a positive slope to the Australian yield curve, a situation associated with positive performance by bank shares – and also undervalued shares in general.

The RBA recently cut its 2019-20 GDP growth forecast from 3.00 per cent to 2.75 per cent and forecast inflation would take longer to return to its target range. Growth was 2.3 per cent over the year to the December quarter. Even if there is another downgrade to 2.50%, banks still face a benign mix of no imminent hard landing and policy stimulus. Meanwhile, the buoyant trade surplus increases private saving of foreign currency and Australian dollar depreciation supports domestic firms in the tradables sector.

Westpac has significantly derisked by reducing the proportion of interest-only loans to 31 per cent of its mortgage book. While this is still well above peers, the ratio is down from a peak of 50 per cent two years ago.

We have noticed a trend towards more short-termism in some analyst research on banks and not enough credit for the generally solid execution of core strategies by major bank management teams. Once remediation costs have peaked, banks will cycle depressed earnings, organic capital growth should start to overtake remediation costs, and this should support sentiment on the sector. In Westpac’s case this will come some time in fiscal 2020, when the bank will provide for its costs in remediating customers of its aligned advisers. Provisions for remediating customers of salaried advisers are being taken in fiscal 2019. Meanwhile Westpac continues to reduce its underlying operating costs to offset the lack of revenue growth but is still investing in its strong customer franchise. Guidance is for a one per cent reduction on the 2018 cost base.

The regulator APRA’s move this week to reduce the minimum interest rate for mortgage servicing assessment from 7 per cent to the bank’s lending rate plus a 2.5 per cent buffer increases maximum borrowing capacity by around 9 per cent but up to 14 per cent after RBA rate cuts. The bipartisan first home owner’s deposit insurance scheme proposed in the election campaign signalled the political system’s appetite to relax collateral requirements for this cohort. Both measures should stimulate home lending and support bank interest revenue.

After National Australia Bank recently cut its dividend, attention has turned to Westpac as the next bank which could also cut. Given the bank’s adequate capital position, at this stage we think discounted and/or underwritten dividend reinvestment plans are more likely given Westpac’s appetite to distribute its flow of franking credits. Share issuance from the currently discounted DRP is pressuring EPS growth but in our view, it would take a material surge in bad debts expense for capital to come under sufficient pressure for a dividend cut to be necessary to protect the balance sheet.

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